What is diversification?
Diversification is the concept of spreading out your investments across different asset types and sectors, and by choosing a mix of investments that tend to perform well at different times.
It’s used by all types of investors — from beginners to experts — to help mitigate risk, keep a stable portfolio during moments of volatility or unexpected market movements, and increase the likelihood of steady returns over the time period that aligns with your goals.
When you diversify, you mix a variety of different investments in your portfolio. So instead of investing only in stocks, let’s say, you might spread your investments across different types of assets — like stocks, bonds, and real estate.
That’s just one type of diversification strategy. There are several different methods, based on what elements of an investment can be diversified. Here’s a closer look at what can be considered a factor for diversification.
Asset classes
Investing in different categories of assets is a common way investors think to diversify their portfolios. Holding a mix of things like:
Stocks
Bonds
Private equity
Private credit
Real estate
Cash or cash equivalents (such as money market funds or Guaranteed Investment Certificates [GICs])
Cryptocurrency
Sectors
Stability varies by sectors — some stay fairly consistent, while others move based on industry changes. By diversifying with stocks or ETFs of companies from a range of industries, the performance of your portfolio isn’t completely dependent on the goal of one sector doing well. Common sectors include:
Technology
Energy
Consumer goods
Utilities
Telecommunications
Healthcare
Geographic locations
Similar to spreading your investments across sectors, spreading investments across companies based in other countries means your portfolio’s performance isn’t entirely reliant on the health of one country’s economy (which can be impacted by things like weather events, political unrest, and so on). You can look to different markets like:
Canada and the U.S.
International developed markets (countries with similarly mature, dependable economies and stable regulatory systems, such as Japan, France, the U.K., Sweden, Singapore, etc.)
Emerging markets (countries in the midst of transitioning to modern, industrial economies, with potential for high growth, such as Mexico, China, Brazil, Saudi Arabia, and Pakistan)
Risk, lifecycle stage, market size
You can diversify further by choosing assets with different risk levels (so long as you can handle varying risk levels). If you’re investing in stocks or private equity, you can diversify by varying lifecycle stages and market capitalization.
Risk profiles: An assessment of how risky any investment is based on a variety of factors, such as how volatile it has been over time and what market conditions it is subject to.
Defensive stocks: These are stocks that have similar expected returns but also perform well at different times. This approach does give up on some upside, but it also reduces the risk of a bad outcome, while keeping expected returns the same.
Lifecycle stage: Growth stocks are companies that expect to grow faster than the overall market, but can be volatile, while value stocks are established companies that aren’t expected to see much more growth, but are considered more stable.
Market capitalization: The total value of a company's outstanding shares of stock, which represents the company’s overall value as perceived by the market. Higher cap stocks are typically stable, more established companies, while lower cap stocks may have more risk but have historically had higher returns.
Why is diversification important?
Diversification is a risk management strategy for investors, and being comfortable staying the course through volatile or unexpected moments is a key element of investing. When you diversify your portfolio, you’re ensuring that you’re not relying on one single type of asset, which helps protect your portfolio from market volatility — and helps keep you comfortable and invested through turbulent or unexpected moments. The thinking goes that if your portfolio is fairly well protected from risk, it will net higher returns over the long term.
Think of a specialty bulk candy store — the kind with rows and rows of bins containing both old favourites (like gummy worms) and strange novelties you’ve never tried (hot dog-shaped marshmallows with an indistinguishable flavour). If you’ve got a $10 bill burning a hole in your pocket (and a pretty serious sweet tooth), how do you spend it?
You could just stick to the classics, but you might find the flavour payoff to be pretty modest. It’s tempting to fill your bag with the wild card candies, but what if they’re too waxy or too licorice-flavoured and you don’t want to eat any of them? That’s money down the drain (and gross candy in the trash).
But if you fill your bag up with mostly safe bets, then throw in some of the novelties, it’s not a big deal if the hot dog-shaped marshmallows are a bust — you’ve still got plenty of reliably good candies to snack on. The positive performance of some candy offsets the negative performance of others.
That’s why diversification is important. Here's a less sugar-based example: in the 2008 financial crisis, people that had portfolios that were nearly entirely composed of housing-adjacent stocks, such as banks and mortgage companies, suffered huge losses when the housing market collapsed and those previously successful companies went bankrupt (or nearly bankrupt). Those investors with portfolios that comprised an array of different assets — even if that array included some banks and mortgage companies — likely fared much better and recovered more quickly.
How to diversify your investment portfolio
When it comes to diversifying your portfolio, how you do it comes down to whether your portfolio is self-directed (DIY) or managed (by a professional or platform).
Self-directed
If you’re a DIY investor, the level of diversification and how you diversify (whether you spread out across sectors, geographies, and asset types) is up to you. Diversification can look different for every investor, based on how much money they’re working with, what assets they’re interested in, and how much risk they can tolerate. What’s most important is to understand the risk profile of each individual investment and how much risk you can tolerate, before you decide how much money to invest and where.
Managed
A well-managed portfolio — whether it’s managed by an individual or firm, or a smart investing platform — is probably already diversified. Looking at an analysis of your portfolio can help you understand how your assets are currently allocated. If you want to diversify it further, you can request to rebalance it with your portfolio manager, change your risk portfolio (if you can tolerate further risk and that strategy aligns with your investment goals), or add some self-directed investments to the mix.
Pros and cons of diversification
Investing always comes with risk, even if your portfolio is diversified. That being said, here are some reasons why diversification is a popular investing strategy — along with a few potential drawbacks to consider.
Pros of diversification
Managing risk. A diversified portfolio can be helpful in minimizing your risk as much as possible. A portfolio consisting only of one stock or in one sector is at-risk if that particular company or sector experiences a downturn. It’s much more unlikely that, say, 25 companies across various industries or five different sectors go down at the same time.
Preserving capital. While diversification usually won’t lead to any extreme short-term growth, it can be a is a popular method of preserving the capital you already have while benefiting from steady, long-term growth.
Access to different assets. Want to dip a toe into the world of cannabis stocks? Are you passionate about renewable energies? Keen to add some blue-chip stock to your portfolio? Diversification allows you to incorporate many types of investments at the same time, while leaning on other asset classes and industries to balance things out.
Possibility of higher long-term returns. As mentioned before, there are no guarantees when it comes to investing. But a diversified portfolio can help increase the odds that you’ll be in on the fun when certain companies or industries start generating high returns. And even if that doesn’t happen, a well-diversified portfolio will usually experience a steady — even if it’s slow — growth that mirrors the growth of the market.
Cons of diversification
Limited short-term gains. Because diversification means not betting a significant amount on a specific company or sector, it means that you could miss out on significant short-term gains if your bet turned out to be fortuitous. Let’s say you invested $100,000 equally across 10 stocks, and one of those stocks has a sudden and sizable increase in value, almost doubling its price. That means you’d now have a $20,000 stake in that stock. Had you invested the entirety of your $100,000 in that one stock, you’d have a value of $200,000. But remember: the risk of incurring significant losses also increases when you invest in this way.
Can be difficult to manage. If you’re taking a self-managed approach to investing, you’ll need to spend a lot of time researching, tracking, and rebalancing your portfolio if you want to keep it diversified.
Potential higher fees. Whether you’re managing your portfolio yourself or paying a financial advisor or portfolio manager to do it, more assets can sometimes mean more fees. You’ll likely be paying commission and transaction fees to hold a large range of assets, especially if you’ll be trading often.
Increased risk without a strategy. If you’re investing in anything and everything for the sake of diversifying, you could actually increase your risk. That’s why evaluating the risk profile of every investment type is essential.
Final thoughts on diversification
Diversification isn’t a guarantee against losses. But a well-diversified portfolio will almost always face less risk and deliver more stable results — even if those results don’t include sudden and extreme upswings. But as with every investment strategy, remember: it only works if it suits your goals, investment style, and most importantly, your risk tolerance.
